Patents and Innovation Economics

Jump Starting a Secondary Market for Patents

I suggest that the companies involved in standards organizations create a company to administer the standard. This standards company would essentially be a licensing and development company. The standards company would also create improvements on the standard and solicit others to contribute their inventions/patents. Outside companies that contributed patents to the standards company would either receive equity or a royalty payment. These standards companies would advance the concept of a secondary market for patents.

Standards organizations (such as IEEE 802.11 for wifi) are commonly formed by a group of companies to define a transmission or interface protocol. The companies agree to pool their patents that are necessary to implement the standard. They also agree to license their patents on a nondiscriminatory basis for a reasonable royalty. Commonly, a company wishing to build a product implementing the standard takes a license to the pool of patents and pays a royalty. The royalty payment is then divided among the companies that contributed patents based on the number and importance of the patents each company contributed.

If the companies involved in a standards organization agreed to create a company to administer the standard it would decrease the politics associated with the standard, increase the diffusion of the standard, and increase the licensing revenue collected. The founding companies could either receive equity or licensing revenue from the standards company. The standards company could either sell equity or pledge the royalty income to issue bonds. Founding companies could realize value from the creating a standards company that is presently latent.

One method that the company could use to raise initial capital would be to issue bonds backed by the royalty income from the standard. These bonds would be similar to Bowie Bonds, which were issued in 1997. David Bowie raised $55 million at 7.9% by pledging the royalties to 25 albums (287 songs) according to Wikipedia. Alternatively, the standards company could issue a combination of equity and debt to raise initial capital. The value of the standards company would show up as an asset on the companies that created the technology underlying the standard instead of just showing up as an expense.

The goal of a standards company would be to see the standard, such as wifi, as widely implemented as possible. Its business model would not be that different than Qualcomm. In the late 1990s, Qualcomm exited most of it manufacturing and product business and instead focused on its core skill research and development. Another company that is a model for a standards company is Dolby Laboratories. Dolby is a technology company that focuses on creating technology and licensing its related patents to the sound recording industry. On of its “principles includ(s) a philosophy not to manage the business for growth’s sake and a focus on innovation and patent protection.”[1]

Unlike companies that normally “try to protect themselves by keeping technology static,” Dolby Labs maintains its edge by taking the lead in generating the ideas that will ultimately displace its own technologies.[2]

The standards company economic interest would be to have as many users as possible implement the standard, since according to most economists this would maximize its income. As a result, it should (and would) price its licensing to maximize the diffusion of the technology. However, it would also aggressively enforce its rights against technology pirates.

Unlike Qualcomm, I suggest that the standards company aggressively seek outside inventors to contribute new technology that would extend the standard or create a new standard. This would reduce its internal research costs, match research investment to return, and expand the pool of talented researchers working on the standard. The standards company would pay these independent researchers either a percentage of the royalties received, or buy out their patents/inventions with cash or equity. Dolby again provides an example.

Continuous innovation also ensures that Dolby Labs rarely goes beyond its own laboratories for technology. For example, in 1998, when the company announced that it would license compression technology directly from another audio technology developer, Ramzi Haidamus, then the Dolby Digital Technology Licensing Manager, pointed out that this was only the second time that Dolby Labs had gone outside for technology. That same year, Dolby Labs partnered with Lake Technology in a licensing agreement giving Dolby Labs access to Dolby® Headphone technology. Dolby’s subsequent three million dollar investment in Lake Technology was the first time the company had ever taken an equity stake in a strategic relationship.[3]

Clearly Dolby has realized that despite its earlier model of developing all its technology internally, it can profit by combining its technology with other inventor’s technology.

The standards company would focus its expertise on application engineers that would help outside companies that wanted to implement the standard and on licensing and enforcement of its intellectual property. It is likely that the application engineers would create many of the extensions and improvements in the standard.

Most manufacturing/product companies are poor at creating intellectual property and even worse at realizing full value from their patent portfolios. Qualcomm and Dolby Laboratories are proof of the power of focusing on technology creations and associated patent protection. A standards company would be a logical division of labor, where talented engineers and scientists would focus mainly on inventing and applications of the technology. The management of the company could focus just on creating value out of an intellectual portfolio instead of having their focus diverted by manufacturing, distribution, and other none intellectual property issues. As a result, they would develop expertise in a standards company that would never happen in a traditional manufacturing/product company. This is the power of the division of labor – thank you Adam Smith.

How does this create a secondary market? A standards company is a secondary market for the innovation by the companies whose technology created the standards company. In addition, the standards company would openly solicit new technology that they could license. This would create a market for patents that would be similar to the Apple apps market. The success of a standards company would result in imitation and extend the concept outside this narrow focus. Dolby, Qualcomm, Intellectual Ventures, and NTP are proof that this business model could be extended beyond the narrow focus of technology standards.

Wouldn’t a standards company inhibit the free flow of information? The standards company would have every incentive to make information about their technology widely available, since this would increase the number of people licensing their patents and increase the likelihood that outside inventors would contribute new innovations. A standards company would inhibit the pirating of technology, which is essential to establishing a secondary market. However, it would increase the dissemination of the underlying information.

Isn’t there a risk the standards company would charge exorbitant royalties after luring in users with low royalty rates, since they would now have a monopoly over the standard? Since there are numerous competing standards, if a standards company raised their royalty rates to exorbitant levels product companies would switch to another standard. In addition, if multiple standards companies were created the competition from other standards companies would ensure competition for both new technology and in getting product companies to use their standard. Finally, product companies could demand long term licenses to standard that had set royalty rates.

Why would the world want to create a secondary market for patents? A secondary market for patents would reduce the cost of research and development, increase the investment in R&D, and increase the funding for technology start-up companies. A secondary market would also increase the division of labor between production and invention. According to Adam Smith, the division of labor is a major method of increasing the wealth of nations. Innovation is the key to real per capita increases in income and Robert Solow won the Nobel Prize in Economics for proving this. Patents are the method of attaining title to innovation. Only by having title to innovation, can a person trade and capitalize their innovation. Having title to property is critical to economic efficiency and optimization.

[…] Secondary Market/Title Insurance for patents. Before the advent of title insurance it was very expensive to buy a piece of land. You had to pay an attorney for a title report that did not come with any insurance. Lawsuits over the boundaries of real property were epidemic before the advent of modern survey tools. Patents are in the same position where no title insurance has been created. Unfortunately, antitrust law undermined the first efforts to create a title insurance/secondary market for patents. Patent pools were a way to determine the validity of patents, enforce patents, and widely license the patents in a cost efficient manner. But the antitrust idiots said that they were illegal. Today, Luddites are using the rallying cry of “patent troll” to kill off the beginning of a secondary market – see https://hallingblog.com/2009/09/18/in-defense-of-patent-trolls/ For more information see Jump Starting a Secondary Market for Patents https://hallingblog.com/2009/11/16/jump-starting-a-secondary-market-for-patents/. […]